Download Money, Liquidity

Balance Sheets, Money, Liquidity and Finance
Balance Sheets
• Every economic unit has a balance sheet. Governments, businesses, households, all have
balance sheets. You have a balance sheet, even if you never write it down. A balance sheet is
simply a list of the unit’s asset and liabilities. We often write balance sheets with assets on
the left and liabilities on the right.
• An asset is anything you own that you expect to receive income from in the future. A liability
is an obligation to make a payment at some time in the future. A liability is a commitment
to make a payment in the future. For our purposes, we can think of a liability as being the
same as a debt.
• A financial asset is any kind of claim that requires someone else to make payments to you
in the future. For example, if you borrow $20 from me and give me an IOU, that IOU is an
asset for me, because it represents your obligation to pay me the $20 sometime in the future.
Various kinds of debt and equity (stocks) are the most familiar financial assets, but there are
many others. A real asset is something you expect to receive income from not because anyone
is required to pay you, but because you can use it in some way that will benefit you. The
machines and buildings owned by a business, or the house and car owned by a family, are
examples of real assets.
• Every liability is an asset for someone else. (If you owe money, there must be someone you
owe it to.) Every financial assets is a liability for someone else. Real assets are not liabilities
for anyone. Everything on a balance sheet is a stock (as opposed to a flow). Net worth is a
special kind of liability. It is defined as total assets minus total financial liabilities. It may
sound strange that net worth is a liability, but that is how it is treated in accounting.
• Financial transactions involve changes in balance sheets. Every real transaction has a corresponding financial transactions. But many financial transactions have no connection with real
transactions.
Money
• There are four functions of money:
1. Medium of exchange. Money is something you can give in return for a god or service.
2. Unit of account. We measure the value of things in terms of money.
3. Store of wealth. If you have more income right now than you want to spend, you can
hold money to give you the option of spending later.
4. Means of payment. If you have a debt to someone, they will accept money to settle it.
This is the function of money that is connected to an asset’s status as legal tender. By
law, anything designated as legal tender (dollar currency in the US) must be accepted in
payment as a debt. Legal tender does not have to be accepted as payment for goods or
services.
Note: The textbook only discusses the first two of these functions.
• Many assets perform some of the functions of money, but not all of them. Different assets
perform the functions of money at different times. For example, in a country with high
inflation, people might use the local currency to buy goods and services settle debts, but not
as a store of value. So there is no hard and fast rule about whether a given asset is or is not
money. In many times and places, no single asset performs all of these functions, any it does
not make sense to say that anything is “money".
• Economists used to talk about the "quantity of money," and describe central banks as "printing
money" or "controlling the money supply," but that kind of language is no longer used. There
is too much fuzziness about what does and does not function as money, for there to be a
meaningful quantity of it.
Liquidity
• The liquidity of an asset refers to how easy it is to trade it or convert it into money, by selling
it, borrowing against it, etc. Liquid assets should have low transaction costs a predictable
value, thick markets, and come in standard form. And it should be easy to buy or sell them
without having to change what you are doing. A financial asset like a bond is very liquid –
there are well-organized markets with lots of buyers and sellers, one bond is just like another,
and owning a bond and collecting interest from it doesn’t require you to do anything else. A
stock is less liquid because its value is unpredictable – you might not be able to convert into as
much cash as you were expecting, when you need it. A piece of machinery, a building, a house
are much less liquid – each one is a little different, so it’s harder to find buyers, and there are
often significant costs involved in transferring ownership. And to get an income from it, you
have to actively do something with it.
• Any asset that will function as money must be liquid. Another way of thinking of liquidity is
the "moneyness" of an asset. Something you can easily convert into money when you need it,
is almost as good as holding money itself.
• As applied to a balance sheet of a business, household, or other economic unit, liquidity refers
to how easily they can acquire money when they need it. Holding money obviously makes
your balance sheet liquid, as does holding liquid assets. But an economic unit may also be
liquid if it is easy for them to borrow money.
Finance
• In any monetary economy, there is a circular flow with goods and services flowing in one
direction and money flowing the other way. Total spending always equals total production.
But individual units can spend more or less than their income.
• The financial system is what allows us to make spending decisions independent of our income.
If we want to spend less than our income, we acquire a financial asset – in effect, we make a
loan to the financial system. And if we want to spend more than our income, we can borrow
– that is, we add a liability to our balance sheet, which is an asset for the financial system.
• Most of what we use as "money" is actually liabilities of the financial system. Your bank
account is really a debt the bank owes to you. When you pay someone, you transfer that debt
to a third party.
• Reserves are a special money that banks use to make payments to each other. They are a
liability of the central bank.
• Every time a bank makes a loan, it creates money. The loan is really two offsetting debts
– your debt to the bank, and the bank’s debt to you in the form of a new deposit. If you
borrow $100,000 from a bank, your assets and liabilities each increase by $100,000, and so do
the bank’s. The loan is an asset for the bank, but the deposit – the money you now have – is
a liability.
• So the total amount of spending in the economy depends strongly on the terms on which banks
are willing to extend credit. In effect, the financial system regulates the flow of payments
through the rest of the economy. That is why it is so important for macroeconomics and
macroeconomic policy.
• Not all credit finances purchases of real goods and services. It can also be used to finance asset
purchases. The more liquidity there is in the economy, the easier it is to finance purchases of
assets, so the more demand there will be mroe assets and the higher the price of them will go.
This is why easy credit is often associated with asset bubbles.
• An asset bubble is a situation in which people buy an asset primarily because they expect
its price to go up. (An increase in the price of an asset is called a capital gain.) If enough
people expect the asset price to rise, then demand for the asset will cause its price to rise. So
people’s optimistic predictions come true, and demand for the asset will rise further. In other
words, there is a positive feedback loop between demand for its asset and the price of the
asset. (This is different from the negative relationship between price and demand that exists
in normal markets.) But it’s not enough for people to want more of an asset, they also have
to be able to pay for it. So easy credit is an essential ingredient for asset bubbles as well.